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Do You Hate Paying High Taxes? Me Too. Here’s the REAL Problem…

by Ben Leybovich on March 18, 2014 · 33 comments

  
The Problem With High Taxes

My friend and colleague Mark Ferguson published an article a few weeks back in which he made the argument that high taxes are a good thing.  In his view, since paying more taxes is indicative of having earned more money and higher productivity, high tax bill should be viewed as a sort of a metric of success…

While I am not about to argue that money and earning high income is bad, I do happen to see things differently from Mark relative to taxation.

Related: I Like Paying My Taxes (You Might, Too, After Reading This!)

PROBLEM WITH PAYING HIGH TAXES

Let me preface this discussion by stating that while I am very fiscally conservative, I am not one of those conservatives who feel that government and taxes are inherently evil; some days I do, but not by and large :)  I do think that everyone should re-pay the society for the incredible opportunities which it offers us, and if taxes are a price to pay than so be it.  Furthermore, I have the view that as an entrepreneur I will always find ways to make more money if I need to.  Taxes are not likely to impact my ultimate success in a negative fashion.

Having said this, though, I am capitalist through and through.  I use other people’s money, time, and talents to advance my goals, and in this vein I do not believe in paying any more taxes than I absolutely have to and legally am obligated to.  I am, indeed, of the opinion that I can deploy capital much more efficiently than Uncle Sam…

With this in mind, I think that paying 40%-50%, and in some cases higher, effective tax rate is unproductive, unnecessary, and kinda stupid – yet many high income earners do just that.  Interestingly, the law certainly does not require anyone to pay this much – it’s a choice people make.  If you pay that much tax, it is indicative of something, but I am getting ahead of myself…

LOOK AROUND

I know many people who believe the way Mark believes – having to pay more taxes is the price of being more productive; it’s a function of having earned more money and is indicative of success.  But, how can this perspective be reconciled against the reality out in the economy?  Just take a look at the wealthiest members of our society – Mitt Romney, Donald Trump, Koch Brothers, and Warren Buffett have been in the news the past couple of years.  All make more money annually than a human being will ever know what to do with, and yet all pay a very low effective tax rate; likely in the neighborhood of not more than 15%.

Knowing this, how can it be reasonably argued that a high tax bill is necessary, desirable, or smart? Can it really be indicative of financial success?  In fact, a reasonable observer would have to extrapolate that these people’s prodigious financial success is specifically a function of having low exposure to tax for a prolonged period of time…

THE CRUX OF THE MATTER

The truth – earning high income is not at all the reason why someone pays high taxes.  Indeed, the reason people pay high taxes is not simply because their income is high, but because it’s the wrong kind of income generated in the wrong way.  Thus, I am not at all against high income – only against wrong high income…

3 Types of Income

The internal revenue service groups all income into 3 categories:

  1. Earned Income
  2. Passive Income
  3. Portfolio Income

1. Earned Income – W2 and 1099 income.  This type of income should be thought of as trading hours for dollars.  It can also be thought of as “personal service,” meaning that if you are not there to render service and put-in time, then there is no income.

Because of this, earned income presents challenges relative to financial security and stability, which is likely why you are here studying about real estate in the first place – you want to say good buy to your boss as much as the next guy and you figured out that real estate can be a good way to do just that.

But, aside from financial security and stability, which are inherently and by definition impossible in the world of earned income, earned income also presents big challenges relative to wealth accumulation in that of the three types of income it is by far the most highly taxed.  Not only is the 2014 tax bracket for highest income earners relative to Earned Income category sitting at 39.6%, which in and of itself renders earned income highly inefficient, but it is also subject to the Social Security and Medicare Taxes (also known as FICA taxes).

Indeed, it is not uncommon that someone earning $500,000 annually will have 50% effective tax exposure – or more!  This means that for 6 months out of the year this person/family works for nothing more than just to pay the tax bill!!!  Talk about inefficient…

2. Passive Income – Income resulting from passive cash flow from real estate and business ownership.

3. Portfolio Income – Income which results from paper investments.

Both Passive and Portfolio types of income are created through investment activities of one sort or the other, and both come with much lower tax basis, plentiful shelters, and no FICA exposure.

Related: The Truth About Active Income vs. Passive Income

PERSPECTIVE

Relative to money, how much you earn is much more 2consequential than how much you keep, and how much you keep is very much a function of controlling your tax exposure since tax is by far your biggest expense.  If, for example, you’ve established that in order to maintain your desired quality of life you need to Net Cash Flow $200,000/year, then presuming a 50% effective tax rate you would need to earn $400,000.  However, presuming a 10% effective tax rate you would only need to create $220,000.  See what I mean – how much you keep, not how much you earn…

And here’s the thing – pay attention to this:  Most people erroneously believe that a graduated taxation system means that the more you make, the more tax you pay.  But, this is only partially true and only as it relates to earned income.  Indeed, the level at which you are taxed is much more a function of HOW you earn rather than how much.  Thus, the very potent question to ask yourself is:

Question: The activities that I am involved in every day which earn me $300,000 – are they the type of activities that will ever bring me closer to converting the face value of my earnings from earned to passive and portfolio?  If I stopped working today – what adjustments to my life-style would I have to make…?

SO – WHAT EXACTLY IS THE PROBLEM THAT BEN HAS?

Well – my wife would likely tell you that I have many problems, and I never argue with Patrisha.  But, relative to high taxes, follow my logic:

  1. If your tax exposure is high, this is indicative of earning high earned income
  2. The reason you have to earn a high earned income is because 1) you enjoy a fly life-style, and 2) you are penalized so much via taxes.  This is a circular function of earning more and paying more taxes and spending more after-tax, which leads to lower and lower efficiency in your earning capacity.  Furthermore,
  3. In order for you to earn so much, you have to spend a lot of time at work…
  4. Ben doesn’t like to spend a lot of time at work, and more importantly…
  5. Because of the MS diagnosis, Ben does not have the luxury of relying on being able to continue to spend a lot of time working in perpetuity. Ben cannot get used to relying on paying for his life and retirement via earned income!
  6. Therefore, Ben chooses to focus on creating money, not earning money – that’s the difference of passive vs. earned…
  7. Because of this, Ben’s effective tax rate is quite low…
  8. Since Ben’s tax exposure is low, he therefore doesn’t have to earn nearly as much money as most to substantiate a life-style that a lot of people with much higher incomes lead…
  9. But, it is indeed hard to create substantive amounts of income which the IRS would classify as passive – it takes time and lots of knowledge…
  10. Therefore, Ben’s family leads a rather frugal life-style.  Ben could have a couple of beamers in the garage – Ben and his wife Patrisha choose not to!

TO WRAP IT UP

Financial Independence, in my opinion, is measured in units of free time more so than units of currency.  Financial independence is a function of creating income without needing to show up; it is a function of how little you have to work to sustain your life-style, not how much you made while being a slave to the system.

It makes sense to me, therefore, that if financial independence is what I want and need, focusing on passive income generation is vastly more important than earning high income of the wrong kind.  And the tax code, which was written by capitalists for capitalists, agrees with me and this is why I pay very little tax compared to most…

Does Ben’s thinking make sense to you? :)

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{ 33 comments… read them below or add one }

Joe H March 18, 2014 at 5:56 am

Genius. You just made me connect the dots with high tax bill. If I rely on commercial banks to raise capital then I am forced to understate expenses and pay higher taxes so the debt ratio is “good”. If I continue to seep private money, it will be cheaper in the long run because I can accurately exploit the tax code. Thanks for this.

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Ben Leybovich March 18, 2014 at 6:28 am

:) Not only that, Joe – while finance-ability commercially is a function of Debt to Income Ratio, private money doesn’t care about that at all. This means that if you operate in the world of private money, your world is without limits…

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Joe H March 18, 2014 at 8:00 am

Thanks for this, don’t want to hijack the topic. Took down 100 at 12 with three. Colleagues tell me I’m crazy. My return has officially become infinite and all credit card bills for the rehabs are paid off. Mwoohahah

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Ryan Ebanks March 18, 2014 at 6:50 am

Ben, there have been many discussions on this and I believe your style of writing helps to bring the point home. There are often so many missed opportunities because of lack of information, knowledge and acting on this information and knowledge.

True Story: I had an interesting observation at a REIA seminar at a prestigious country club. The meeting was oversubscribed and attendees were in the hallway. You could hear the snickering and see the smirks of some of the club members as they passed by and made fun. Fast forward a bit and one of these former high flyers was desperately trying to dispose of his high end assets because of financial crisis. Moral of the story – many depend on earned income and lead a life of debt-driven prosperity failing to understand and manage associated risks. Guess who bought his house for 50cents on the dollar – one of the seminar attendees…

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Ben Leybovich March 18, 2014 at 9:53 am

Nice hahaha!

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Sharon Tzib March 18, 2014 at 8:39 am

It absolutely makes sense, Ben. When I get back to the States, my goal will be to use private money as efficiently as possible to reach my goals as quickly as possible; however, I can accelerate my goals quicker by combining that with funds from earned income, capitalizing on skills I have that are marketable and can earn me a decent living, to make REI purchases as well. So to answer your question:

“The activities that I am involved in every day which earn me $300,000 – are they the type of activities that will ever bring me closer to converting the face value of my earnings from earned to passive and portfolio?”

Yes, they will be as long as I control my expenses and live as frugally as possible. Otherwise, I could remain trapped in the earned income hamster wheel like so many people do, which I think is one of the biggest reasons why people don’t reach their goal of financial freedom sooner. Living in Belize for the last four years has taught me how to live quite conservatively, a practice I plan on continuing in the States. Thanks!

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Ben Leybovich March 18, 2014 at 9:53 am

As long as you control your expenses – the operative concept Sharon.

I used to believe in abundance of means, which led me to chase shiny objects all day long. Sure – we can make money that was. But, then I realized that I don’t need too much – just enough…

“Cannot people realize how large an income is thrift? “ ~ Cicero

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Mark Ferguson March 18, 2014 at 8:57 am

Ben, thank you for the grat analysis. I do diagree though! in my article I neer said one should not try to pay as little taxes as possible. I said one should not ignore earned income just because it has a higher tax rate. Do you have any statistics on how many people that earn $500,000 pay 50% in taxes? That seems ridiculous be ause we are in a tiered tax system and the money they earn below the top tax rates is not even close to 50% and neither is the top tax rate. I know state income taxes are crazy in Cali, but people do t pay the highest rates. Most high income earners have business and many deductions. Those deductions greatly reduce a tax bill. I am in the top tax bracket and pay much less than the affective tax rate because of deductions and investments.

As far as Buffet and other high income earners they are not in an active income earning stage. They are in an investing stage. What were their tax rates when they were building their wealth, running companies and actively earning? The way they got that wealth was not by just using passive investment. Buffet didn’t make his billions buying stock, he made it buying and selling companies. Call him a company flipper.

The truth is I want to make as much money as possible. That means using a mix of passive, earned, and portfolio income. The fastest way to grow passive income is to use earned income. In te last 3.25 years I have bought 9 rentals and probalably invested between $270,000 and $300,000 into those properties to buy and repair them. I am making between $5,000 and $6,000 a moth in passive income from those rentals and my networth has increased $500,000 from those properties. I buy below market, I repair and appreciation has been strong.

If I did not have earned income because I didn’t want to pay taxes on it, I would not make nearly as much money. I would not be able to buy nearly as many properties. I could buy them with little money down and use private money, but I would pay much more for the properties and pay much higher rates. That equals less returns and less net worth increase.

One last point; earned income does not have to be a one man show. You are not trading dollars for dough. I have 9 people on my team and I am in Mexico as we speak looking out my window at the beautiful green blue waters and white sand beach. I am not working, my team is.

Sorry I forgot one thing. Isn’t the product you created and worked your butt off for a form of earned income? Yes it may be mostly passive now that you have created it, but it is still taxed at a high rate correct?

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Ben Leybovich March 18, 2014 at 9:48 am

Hey Mark – so you stated the biggest difference between us. While you want to make as much money as possible any way that you can, I only want to make “enough” but without my material involvement day to day… That is a huge difference in perspective. I am sure we will both succeed in achieving our goals.

P.S. I chuckle at myself since a syndication is anything but passive. In my defense, I do get equity as pay for my efforts, which makes the time spent justifiable in my mind :)

As to your last point – yes, I did spend many hours throughout 2012 creative CFFU. But, since then my commitment has been very light indeed. I am OK with targeted and limited time commitment to build a pipeline so that later I can benefit from it – you know exactly what I am sayin’

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Mark Ferguson March 18, 2014 at 1:09 pm

Ben, since you are pursuit new ventures like sindication and you created a product to sell doesn’t that indictate that your current goals are not being met fast enough? Those two ventures may not require as much time once they are set up as a regular job, but they are still taxed the same. That’s my whole argument. My team does most the work and I make money not working all the time. I dot mind if that money is taxed higher because it is still more money in my pocket than if I didn’t have a team making money.

I don’t look at tax percentages. I look at after tax dollars. My team makes such and such a month after taxes. It is taxed higher but the take home pay is much higher than the 5-6k I make off my investment properties even though they are taxed lower.

Hypothetical; I make $500k from selling houses and flipping and my blog. I take home $300,000. I make $60,000 off my rentals. I take home $50,000 after depreciation. It’s great I take home a higher percentage but I still make much more off the e real estate business.

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Chad Carson March 28, 2014 at 8:53 pm

Mark, I have a lot of respect for your drive and desire to make as much money as possible. But where you seem to keep a balanced perspective, too many people on that more-and-more money train seem to lose it.

That’s why I think Ben’s contrarian emphasis on multiple currencies and on “enough” is really a much needed message for go-getter entrepreneurs like me who tend to live in the future, who love to achieve, and who forget that tomorrow isn’t promised.

You both do a good job articulating this dilemma I often struggle with – how to keep growing and challenging myself (my strength) while also slowing down to invest in more subtle, less quantifiable pleasures of life – like good health and quality family relationships.

Thanks to you both.

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Adrian Tilley March 18, 2014 at 9:34 am

Ben,
Can you elaborate on the distinction you make between earned and passive income? I’ve never heard anyone claim that these are taxed differently. Are you categorizing passive income as dividends? Unless I’m mistaken, rental income is still considered earned income by the IRS. Flipping profits could be taxed as long term capital gains if the property is held for more than a year, but most flippers don’t want to hold properties that long, and instead they are taxed as short term capital gains, which are at the normal tax rates. So what’s the benefit of “passive” income from a tax perspective?

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Ben Leybovich March 18, 2014 at 9:41 am

Hey Adrian,

Any income that is not subject to FCIA is desirable income in my view. Dividends and interest, while taxed as ordinary income are not subject to SS tax, long-term capital gains. Flipping houses is a business taxed as ordinary income which includes SS tax, unless held for over 12 months. Same as trading of paper. Basically, any income which requires your “material involvement” is taxed higher than income generated without material involvement, or passively – domain of investing.

Thanks Adrian

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Jason R March 18, 2014 at 10:55 am

Rental income is passive income, not earned income. Passive income does not pay FICA taxes. This is 15.6%, even more if you make >$250k filing married and joint. (Thank you, Mr. Obama)

If filed correctly, flipping is NEVER a capital gain no matter how long you hold it. If your occupation is house remodeling (flipping), your earned income is generated from house remodeling. If you happen to hold one of your projects in your “inventory” for 2 years, it does not suddenly become a capital investment. The crux lies in your intent for the property. Did you buy it to flip like the other 20 flips you did that year? (and the 20 last year…oh, and the 20 you did the next year.) Or, was this one “special” and you intended to hold it as an investment? You can argue about with the IRS if they ever audit you. :) Bear in mind, I am being very technical here. You should know the facts, then choose your personal path in accordance with your beliefs and values.

Ignorance of the law is not an excuse. If you’ve been pulled over for going 45 in a 30, you know EXACTLY what I mean. Tax law is the same. Some of the largest tax audit assessments on individuals come from the IRS reclassifying income.

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Joe H March 18, 2014 at 6:54 pm

You just saved me untold thousands. Thank you.

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Sharon Tzib March 18, 2014 at 11:11 am

The beauty of passive income, Adrian, is how you are taxed. With earned income, you get paid a salary, pay your taxes, and then you get to spend what’s left. With passive income from real estate or a business, you earn your revenues, pay your expenses, take your depreciation (if applicable), and then get taxed on what’s left. This is why passive income is so powerful and much more favorable than earned income, and it can be used to offset your earned income (if you have both types) and help lower your tax rate.

Any competent CPA can help you understand the distinctions.

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Ben Leybovich March 18, 2014 at 11:40 am

Exactly Sharon!

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Adrian Tilley March 18, 2014 at 12:45 pm

I think Ben and Jason answered by question above – you’re only ever taxed on net income, whether from work or investments.

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Nick March 18, 2014 at 10:56 am

Great Post Ben!

Phil Mickelson won the Open Championship last year and earned about $1.4 mill for winning. After paying UK taxes, US Federal taxes, and California taxes, he only took home about 40%.

As you pointed out, this same instance translates across the board to any earned income (give or take on the percentages.)

It just doesn’t make sense to me to pay these taxes! However, that’s where we come along and offer different opportunities for people to shelter some of that income :)

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Ben Leybovich March 18, 2014 at 11:39 am

Thanks Nick!

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Mark Ferguson March 18, 2014 at 1:02 pm

I’ll take a $600,000 pay day anytime!

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Ben Leybovich March 18, 2014 at 1:18 pm

Hahaha Mark – you are incorrigible :)

I wish you all of the money in the world. I just want a quite life as much as possible. I will take earned income only if it’s accompanied with equity…

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Galya March 18, 2014 at 1:19 pm

1. All those folks (Trump, Buffet and the rest) are seniors, so they have a bit diferent taxation rules applied to them.

2. W.Buffet paid 19% in 2006 which is $48.1 mln. So yes, 19% doesn’t seem a lot but $48 mln in taxes for a retired guy who donates half of his wealth a year anyways – that’s a WOW. He may be frugal, but he pays a lot of taxes IMHO. In 1954 W. Buffet’s starting salary was $12,000 a year (approximately $105,000 inflation adjusted for the 2012). Don’t tell me he didn’t pay taxes for that. In 1956… Buffett’s personal savings were over $174,000 ($1.47 million inflation adjusted for the 2012). In my words, W. Buffer just worked a lot and paid a ton of taxes.The info is from wikipedia page.

If anyone asks me now, who do I think would be the future W.Buffet on BP based on how much taxes they pay and their strategy with taxes (Ben or Mark), I would say neither, ha-ha. But Mark is choosing the same path, while Ben chooses … something else.

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Dave Tanner March 18, 2014 at 3:58 pm

Touching on Ben & Marks tax articles as well as Mark’s “more money=more happiness”…..
If you can find a happy and fulfilled life at ~$40,000/yr you can pay tiny taxes, and retire very young (free to explore new ideas/projects). If this is your goal you don’t need 100’s of properties, maybe only 12 properties! Lot’s of free time if you only manage 12! A family of 4 making 40k total household income darn near gets a free pass at tax time! But if you’re house is paid off, cars paid off, no debt except rental mortgages (or not), you suddenly don’t need a lot to live on. This is more my approach, but I love that Mark is willing to pay enough tax to cover my “poor” family that pays almost no tax, haha. While Mark searches for happiness behind the wheel of a Lambo, he is already making my dreams possible! :-) Thank you Mark.

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Mark Ferguson March 18, 2014 at 4:17 pm

Haha. I love how much is assumed from people that read my articles. I am a very happy person. When I stopped limiting myself on my money beliefs I became much happier. I have almost no stress in my life right now and if I never made another dime of earned income I could live a fulfilling life. But why not go for more? Why not keep trying? It is fun, it provides a challenge, it is exciting and rewarding. Like I have said many times, we all have different dreams And wants. If your dreams and wants are attainable with less than 40k a year that’s awesome. If someone has bigger dreams then hey should not be afraid to go after them. It is possible to be happy in the now and want more for your future as well. In fact for many people the challenge, game and accomplsihment provide happiness.

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Dave Tanner March 18, 2014 at 4:41 pm

Mark – It’s all in good fun. We are on different paths, we are BOTH doing what we want!

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Galya March 18, 2014 at 6:50 pm

With 40K/year, one family member gets in a car accident (not a lethal one, but a good one, with a few months in an ICU), or one fam member gets cancer, and the income of the whole family is done with, pretty much for good (they would probably need to sell 6 houses, may be even all 12 of them). But they can claim a tax deduction for the medical bills, for sure.

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Dennis March 18, 2014 at 4:08 pm

As my father used to say “It’s not what you make, but what you keep”.

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Ben Leybovich March 18, 2014 at 7:07 pm

I think I used this exact phrase in the article Dennis :)

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Sharon Vornholt March 19, 2014 at 6:51 am

Great post Ben although sometimes you make my head hurt. :)

Smart investors love to create a lot of money, but most of them manage to show a lot smaller income at the end of the day and therefore pay a lot less taxes. You certainly have it right when you say it only matters how much you keep.

Sharon

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Abel Vazquez March 23, 2014 at 4:26 pm

Great article Ben this article reminds me of the whole rich dad poor dad mindset and it certainly makes sense like you mentioned it is not how much you make but how much you keep that actually matters. Thank you Ben.

Abel

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Ben Leybovich March 29, 2014 at 2:15 pm

You are very welcome Abel – thank you for reading!

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JerryW. April 10, 2014 at 9:56 pm

Ben, thank you for your article. I have dabbled in real estate for years and after buying out my partner in a real estate investment company I have felt the bite of taxes pretty hard. Splitting income between several partners was not so bad. Now add more payments for the loan to buy them out and cash flow drops but income taxes rise. I have started taking small steps to offset this like selling my work truck to my company so I can depreciate it and deduct the tires and fuel, and insurance. I will have to continue looking for more deductions.

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